Bond Price For Security Analysis And Portfolio Management MCOM Sem 3 Delhi University : The course on security analysis and portfolio management basically deals with the investment management of the market. Basically, whenever we do the investment in the market, we should take care of certain things before taking part in the financial market. And if those aspects will not be taken care, then it is very difficult to maximize the return with a given amount of the risk or to minimize the risk with a given amount of the return. In this context, it is very much imperative to know certain basic concepts, basic objectives; and as well as the certain theoretical foundations about the secret analysis at portfolio management before going to discuss about that particular issue.

So, today I am going to explain about the introduction to investment management, which deals with the investment philosophy, the investment concept; and how this particular investment is or investment decision is taken in the market. And in this context, we will try to explain certain things like what exactly the investment is, who are the people who can invest, and how we can define the different types of the investor, and as well as how this investment process goes on

Bond Price For Security Analysis And Portfolio Management MCOM Sem 3 Delhi University : So, here whenever we see these things, what basically we look into? First of all, we should know that, what is investment? Investment is the study of the process; investment is the study of the process of committing funds to one or more assets. It emphasizes certain things, it emphasizes on holding financial assets and the marketable securities, which can be traded in the market; and as well as also most of the people can participate in the market. And this concept also is related to the real assets; real asset in the sense, we take the example of housing, we take the example like a real estate market as well as also certain other related market, which are generally concerned with the intangible factors. So, therefore, investment is not confined to only the physical or the financial assets, it basically also related to some of the real variables, which may not be quantified or may not be signified in a physical manner, but still the investor or the people can use those kinds of assets, before investing in the market situation. So, then here whenever we talk about certain things, we should look carefully about their characteristics; and as well as that certain features, how they are different themselves, how we can say one asset is different from the others. Therefore, here basically if you dig talk about the investment philosophy, the investment philosophy is nothing but it is current commitment or the holding of the money of other resources in the exception, in the expectation reaping further benefits, and that will compensate the investor for certain things like the time the investor hold the fund, expected rate of inflation uncertainty of the future.

Let us elaborate this concepts little bit further; what exactly in the investment process or the investment philosophy talks about. The investment philosophy is basically what we do or the investment philosophy what basically explains that one investor invest certain things in the market, expecting that he can get certain return in the future or he can maximize the return in the future. And whenever he takes part in the market, what basically he always sees? He always sees that how much time he will take, and how much time he has before getting the return from the market. And as well as also, he always considers the certain objectives; certain objectives in the sense that whenever we take part in the market, we basically see that if I invest in a particular asset for certain times, this particular in that particular period, my real returns should be maximized. Then definitely the question comes, how to define this real return? So, basically in the financial world, the real return is nothing but the return adjusted to the inflation. And inflation is a buzzword in the market, all of the people who deals with the financial market, they are very much acquainted with the concept like inflation and basically, which talks about the pricing situation in the market.

Bond Price For Security Analysis And Portfolio Management MCOM Sem 3 Delhi University : Bond valuation ore price is the determination of the fair price of a bond. As with any security or capital investment, the theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the value of a bond is obtained by discounting the bond’s expected cash flows to the present using an appropriate discount rate. In practice, this discount rate is often determined by reference to similar instruments, provided that such instruments exist. Various related yield-measures are then calculated for the given price.

If the bond includes embedded options, the valuation is more difficult and combines option pricing with discounting. Depending on the type of option, the option price as calculated is either added to or subtracted from the price of the “straight” portion. See further under Bond option. This total is then the value of the bond.

Bond Price For Security Analysis And Portfolio Management MCOM Sem 3 Delhi University : As above, the fair price of a “straight bond” (a bond with no embedded options; see Bond (finance)# Features) is usually determined by discounting its expected cash flows at the appropriate discount rate. The formula commonly applied is discussed initially. Although this present value relationship reflects the theoretical approach to determining the value of a bond, in practice its price is (usually) determined with reference to other, more liquid instruments. The two main approaches here, Relative pricing and Arbitrage-free pricing, are discussed next. Finally, where it is important to recognise that future interest rates are uncertain and that the discount rate is not adequately represented by a single fixed number—for example when an option is written on the bond in question—stochastic calculus may be employed. Where the market price of bond is less than its face value (par value), the bond is selling at a discount. Conversely, if the market price of bond is greater than its face value, the bond is selling at a premium. For this and other relationships between price and yield, see below.

Present value approach

Below is the formula for calculating a bond’s price, which uses the basic present value (PV) formula for a given discount rate: (This formula assumes that a coupon payment has just been made; see below for adjustments on other dates.)

where:

F = face values

iF = contractual interest rate

C = F * iF = coupon payment (periodic interest payment)

N = number of payments

M = value at maturity, usually equals face value

P = market price of bond.

Relative price approach

Under this approach—an extension of the above—the bond will be priced relative to a benchmark, usually a government security; see Relative valuation. Here, the yield to maturity on the bond is determined based on the bond’s Credit rating relative to a government security with similar maturity or duration; see Credit spread (bond). The better the quality of the bond, the smaller the spread between its required return and the YTM of the benchmark. This required return is then used to discount the bond cash flows, replacing {\displaystyle i} in the formula above, to obtain the price.

Arbitrage-free pricing approach

Further information: Rational pricing § Fixed income securities

As distinct from the two related approaches above, a bond may be thought of as a “package of cash flows”—coupon or face—with each cash flow viewed as a zero-coupon instrument maturing on the date it will be received. Thus, rather than using a single discount rate, one should use multiple discount rates, discounting each cash flow at its own rate.[1] Here, each cash flow is separately discounted at the same rate as a zero-coupon bond corresponding to the coupon date, and of equivalent credit worthiness (if possible, from the same issuer as the bond being valued, or if not, with the appropriate credit spread).

Under this approach, the bond price should reflect its “arbitrage-free” price, as any deviation from this price will be exploited and the bond will then quickly reprice to its correct level. Here, we apply the rational pricing logic relating to “Assets with identical cash flows”. In detail: (1) the bond’s coupon dates and coupon amounts are known with certainty. Therefore, (2) some multiple (or fraction) of zero-coupon bonds, each corresponding to the bond’s coupon dates, can be specified so as to produce identical cash flows to the bond. Thus (3) the bond price today must be equal to the sum of each of its cash flows discounted at the discount rate implied by the value of the corresponding ZCB. Were this not the case, (4) the arbitrageur could finance his purchase of whichever of the bond or the sum of the various ZCBs was cheaper, by short selling the other, and meeting his cash flow commitments using the coupons or maturing zeroes as appropriate. Then (5) his “risk free”, arbitrage profit would be the difference between the two values.

Stochastic calculus approach

When modelling a bond option, or other interest rate derivative (IRD), it is important to recognize that future interest rates are uncertain, and therefore, the discount rate(s) referred to above, under all three cases—i.e. whether for all coupons or for each individual coupon—is not adequately represented by a fixed (deterministic) number. In such cases, stochastic calculus is employed.

The following is a partial differential equation (PDE) in stochastic calculus which is satisfied by any zero-coupon bond.

The solution to the PDE—given in Cox et al.—is:

where is the expectation with respect to risk-neutral probabilities, and is a random variable representing the discount rate; see also Martingale pricing.

To actually determine the bond price, the analyst must choose the specific short rate model to be employed. The approaches commonly used are:

the CIR model

the Black-Derman-Toy model

the Hull-White model

the HJM framework

the Chen model.

Note that depending on the model selected, a closed-form solution may not be available, and a lattice- or simulation-based implementation of the model in question is then employed. See also Jamshidian’s trick.

SIGN IN

Email *

Password *

Important Note – Preparing for MCom?

CAKART provides India's top MCom faculty each subject video classes and lectures – online & in Pen Drive/ DVD – at very cost effective rates. Get MCom video classes from CAKART.in. Quality is much better than local tuition, so results are much better.